Tobin tax is only for textbooks

Financial Express, 21 November 2009

Finance Minister Pranab Mukherjee has laid to rest speculation about India imposing capital controls in the face of rising capital inflows. In a recent statement, he clearly said that while the government would monitor the inflows, India is not planning to impose restrictions on capital inflows in the near future.

The first question that should be asked before a meaningful discussion on imposing restrictions, is about the magnitude of capital flows to India today. The latest balance of payments data is available for the quarter April-June 2009. Net capital inflows in the quarter were USD 6.7 billion. This figure is a fraction of the inflows in late 2007 and early 2008 when they reached highs of more than USD 30 billion per quarter. When we compare foreign inflows today to the two quarters following the financial meltdown, when they were negative, they appear large. But when seen in historical perspective, inflows are, in fact, quite moderate.

Further, if we look at the components of capital flows in April-June 2009, the largest component was foreign direct investment, at USD 9.4 billion. This was followed by FII investment at USD 8.2 billion. The usually worrisome factor, loans, have not bounced back. As a consequence, we saw negative numbers for some categories with net loans outflow of USD 3.3 billion and net banking capital outflow of another USD 3.3 billion.

In the past, an inflow of capital has been a cause of concern for the RBI. One of the main reasons for this was that the RBI was trying to prevent rupee appreciation. When the rupee was touching Rs 40 per dollar, there was pressure from exporters to prevent further appreciation. Today RBI's concerns are quite different. The central bank is faced with the difficult task of trying to boost growth and keep inflationary expectations under control. Were it to raise interest rates, growth could suffer. Were it to lower them, inflationary expectations could flare.

Under such circumstances, rupee appreciation offers an easier path to control inflation. The rupee today, at above 46, still has a long way to go before it becomes a serious lobbying point. Exporter lobbies are not going to be heard particularly seriously at least until it reaches Rs 40 per dollar. Had capital continued flowing out, as it did in the previous couple of quarters, or as it does for loans and banking capital, and had foreign investment not returned, there would have been further rupee depreciation that would have raised inflation rates. The RBI might then have been selling dollars in the foreign exchange market to prevent rupee depreciation and rising prices. This would have resulted in further problems such as a contraction of liquidity.

The return of foreign investment is the best solution to the policy dilemma facing the RBI and the government. Not only does it encourage a stronger rupee, it brings in funds for investment. In a credit constrained economy where domestic banks are reluctant to lend, where foreign loans have dried up, where the non-banking financial sector has seen one of its worst crisis, foreign investment is welcome, and as, the Finance Minister said, much needed by India.

What could be the other concerns because of which there might have been reasons to restrict capital inflows? One concern that is some times cited as a good reason to restrict controls is to reduce buoyancy in the stock market. On this count it is difficult to imagine that the government would, at present, be keen to prick the bubble, even if, like the RBI, it believes that there is a bubble. The stock market is one of the few places where the financial sector is signalling optimism. (Bank credit has still not picked up.) If at this stage the government were to step in with measures such as a tax on foreign portfolio investment, as Brazil has done, it is likely to have an adverse impact on the stock market. In addition to the impact this will have on business sentiment, on a more pragmatic note, this would be bad timing as the government is planning to raise resources by selling shares of public sector companies to lower its fiscal deficit.

Even if all the above reasons for not imposing restrictions are overruled, such as in the event of the exporter lobby becoming overwhelmingly strong, and the government does decide to impose restrictions on capital inflows, it has been seen in the past that capital controls have not been very effective. They appear to be effective in the short run and in terms of the specific category of capital inflows on which they are imposed, but they are not effective in controlling the total amount of money coming in. We have seen that in the case of the ban on participatory notes (PNs), which, of course, stopped money coming into India under the head of PNs, but did not bring down net capital inflows or even total foreign investment into India. There are multiple ways of bringing in money and other than creating distortions in the market, there is little that further capital controls can acheive today. Imposing controls that will make a serious dent on net capital inflows or will bring the number below the last quarter's figure of USD 6.7 billion, is neither feasible nor desirable.